Extensions and Tests of the Classical Model of Trade Chapter 4 McGraw-Hill/IrwinCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

4-2 Learning Objectives  Demonstrate how wages, productivity, and exchange rates affect trade patterns.  Examine the implications of extending the basic model of comparative advantage.  Show that real-world trade patterns are consistent with underlying comparative advantage.

4-3 Adding Money to the Classical Model  Suppose a money economy instead of a barter economy. A wage rate for each country, stated in that country’s currency (e.g., in U.S. $2 per hr., in the U.K., £1 per hr.). An exchange rate that relates the countries’ currencies (e.g., $1 = £1).

An Example 4-4

4-5 Adding Money to the Classical Model: An Example  The U.S. will export wheat, since it can produce wheat for a lower price ($4, as compared with $6).  The U.K. will export cloth, since it can produce cloth for a lower price ($4, as compared with $6).

4-6 The Export Condition  Country 1 should export good j when: a 1j *W 1 *e < a 2j *W 2, where a 1j and a 2j are the labor requirements/hr to produce good j in countries 1 and 2 W 1 and W 2 are the wage rates/hr in countries 1 and 2 e is country 1’s exchange rate (# of country 2’s currency units per 1 of country 1’s).

4-7 The Export Condition  Country 1 should export good j when: a 1j *W 1 *e < a 2j *W 2.  That is, when country 1’s good j price is lower than 2’s, stated in a common currency.  Therefore, the pattern of trade is determined by relative labor efficiency, relative wage rates, and the exchange rate.

4-8 The Export Condition  Country A should export good j when: a 1j *W 1 *e < a 2j *W 2. Let’s re-write this as follows: Country A should export good j when: a 1j /a 2j < W 2 /(W 1 *e).

4-9 Wage Rate Limits  As Country 1’s wage rate goes up relative to Country 2’s, Country 1 finds it harder to sell its exports to Country 2.  As Country 1’s wage rate goes down relative to Country 2’s, Country 1 is less interested in importing from Country 2.

Wage Rate Limits: An Example 4-10

4-11 Wage Rate Limits: An Example  Should the U.S. (Country 1) export wheat? It should if a 1j /a 2j < W 2 /(W 1 *e).  Since 2/6 < 1/(3*0.5), the U.S. should export wheat [or: the U.S. wheat price is $6; the U.K. wheat price is £6 = $12].  It’s easy to show that the U.K. should export cloth.

4-12 Wage Rate Limits: An Example  What if the U.S. wage rate rose to $6?

Wage Rate Limits: An Example 4-13

4-14 Wage Rate Limits: An Example  Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency.

4-15 Wage Rate Limits: An Example  Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency.  Therefore, if the wage rate in the U.S. should rise above $6, the U.K. will no longer buy U.S. wheat (trade will cease).

4-16 Wage Rate Limits: An Example  What if instead the U.S. wage rate fell to $2.67?

Wage Rate Limits: An Example 4-17

4-18 Wage Rate Limits: An Example  What if the U.S. wage rate fell to $2.67?  Now the U.S. cloth price is the same as the U.K.’s, if we state them in a common currency ($8).  Therefore, if the wage rate in the U.S. should fall below $2.67, the U.S. will no longer buy U.K. cloth (trade will cease).

4-19 Calculating Wage Rate Limits Using the Export Condition  Solve the export condition for W 1, for good X.  Solve the export condition for W 1, for good Y.  These will give you Country A’s wage rate limits.

4-20 Calculating Wage Rate Limits Using the Export Condition a 1j /a 2j < W 2 /(W 1 *e) For wheat: 2/6 = 1/(W 1 *0.5) → W 1 = 6 For cloth: 3/4 = 1/(W 1 *0.5) → W 1 = 2.67

4-21 Country 2’s Wage Rate Limits  Changes in Country 2’s wage rates also can affect the pattern of trade.  If 2’s wage rises too much, they will not be able to export any more.  If 2’s wage falls too much, 2 will no longer wish to import.  Solve the export condition for W 2 for each good.

4-22 Exchange Rate Limits  If Country 1’s currency appreciates, imports will seem cheaper and exports more expensive.  If 1’s currency appreciates enough, A will no longer be able to export.  If 1’s currency depreciates enough, A will no longer wish to import.  Solve export condition for e.

4-23 Evaluating the Classical Model  Empirical studies generally show that the classical model is consistent with observed trading patterns.  However, the complexity of today’s world means the Classical model cannot supply a complete understanding of international trade.